The recent launch of several mutual funds of hedge funds (or, more accurately, funds of managed accounts) geared to the US retirement market has turned attention to the question of how much investors should expect to sacrifice in returns for daily liquidity and pricing. Since these products mostly have very short track records, the answer to this question is best found by looking at past efforts to introduce greater liquidity into the hedge fund investment model.

The historical record is not particularly promising. Investable indices were first launched over a decade ago but initially suffered from adverse selection bias that caused one index to underperform its non-investable counterparts by 300-600 bps during its first four years of live performance.[1] More recent innovations like managed account platforms and UCITS structures appear to have a lower performance drag, but making apples to apples comparisons is notoriously difficult. In a recent study, Cliffwater sought to calculate the annual return difference between 148 hedge funds and their direct liquid counterparts, such as managed account platforms, 40 Act funds, bank platforms and UCITS structures. They concluded that investors in the liquid alternative sacrificed approximately 1% per annum due to a combination of fees and lost alpha. They noted that the annual cost was greatest for Event Driven managers (2.3% per annum) and lowest for Managed Futures (0.5%) and Macro (0.2%); Equity Long/Short was close to the mean at 1.1%. However, the performance drag in the Cliffwater study – conducted in March 2013 and based on liquid alternatives that were still in operation at that time – likely is understated since it excludes liquid alternatives that were launched over the past decade but subsequently shut down due to poor tracking.

In this note we seek to estimate the performance drag associated with liquid alternatives to investing directly in hedge funds during the post-crisis period. Rather than analyze individual managers, we look at the recent performance of several indices that track liquid alternatives. As shown in the chart below, a composite of liquid alternatives underperformed the HFRI Fund Weighted and Fund of Funds indices by 3.08% per annum and 1.29% per annum, respectively, over the three and a half year period from January 2010 through June 2013. Factoring in some of the data biases discussed below and variance due to fee structures and strategies, we estimate that it is reasonable for a typical investor in hedge funds to expect a performance drag of 150-250 bps per annum when electing to invest in highly liquid hedge fund strategies.

Data Considerations

At the hedge fund index level there are two principal issues with the data. The HFRI Fund Weighted index is slightly overstated due to reporting bias; that is, funds have a window in which to decide whether to report a given month’s returns. Second, the HFRI Fund of Funds index includes a second layer of fees, which accounts for some of the recent performance differential. In general, we assume that the HFRIFWI is a reasonable proxy for the direct hedge fund portfolio of an institutional investor, while the HFRIFOF is more representative of the returns expected by smaller investors.

With respect to the liquid products, we ideally would analyze the full universe of managed account and UCITS products that are (and have been) designed to track the performance of a given hedge fund so that we can make apples to apples comparisons on a fee equivalent basis – an expanded version of the Cliffwater study. However, proprietary platforms generally restrict access to data and hence make such comparisons impossible or, alternatively, present the data in a self-serving manner. Further, institutions that have negotiated special managed accounts typically do not publish comparative results.

Given these limitations, there are three principal hurdles in the data available to us:

Fee Equivalency. In general, there is very little transparency into whether certain indices (e.g. Lyxor) include platform level fees. Some products, such as the Credit Suisse AllHedge Solutions, are actual investment products, while others merely aggregate reported data. UCITS and registered funds may have materially different fee structures than the actual hedge funds.

Selection Bias. When first introduced, indices are often backfilled and historical results are replete with survivorship bias. Hence, we focus only on live performance. Further, indices that perform poorly can be shut down, as was the case with the Dow Jones Credit Suisse Core Hedge Fund index in May 2013.

Strategy Bias. A liquid index may overweight certain strategies that are inherently more liquid and therefore more conducive to being offered in a liquid structure. Certain strategies like managed futures have underperformed others (e.g. credit) and therefore may depress results. To address this we look at a group of indices rather than focus on a specific provider.

We hope to overcome these limitations by looking at a broad enough sample of indices so that any fund level or platform specific bias has a limited impact on overall results. In light of this, the data shows that there is a consistent and significant performance drag associated with liquid alternatives.

What Causes the Performance Drag?

There are several likely causes of the persistent performance drag. Daily (or near daily) liquidity should limit the investment universe to positions that, by definition, lack an illiquidity premium. If illiquid assets command a 3-4% return premium over time, we might expect a performance differential of perhaps 1% over time if we assume that a typical hedge fund with restrictive liquidity terms might hold a quarter to a third of its portfolio in less liquid instruments. Note that certain liquid hedge fund proxies – such as the Lyxor managed account platform and factor based replication models – outperformed materially during the crisis, which supports the conclusion that at least a portion of the differential is due to a mismatch in the liquidity of the underlying portfolios. However, this clearly does not explain the entire differential.

As noted, adverse selection among managers was very pronounced in the formative years of the investable index business. More recently, established and highly regarded hedge fund managers appear much more willing to run liquid alternative products and the performance differential has narrowed. The persistent performance drag even in recent years suggests that investment restrictions in more liquid products cause a portfolio-level form of adverse selection.

Another cause, as noted by Callan in a recent research report on alternative mutual funds, is that registered funds and similar vehicles restrict leverage, which can be a key contributor to returns in certain strategies. A fourth likely cause is that managers need to retain a cash buffer to manage more frequent inflows and outflows.

The mix of factors clearly will vary from product to product and strategy to strategy. Cliffwater’s conclusion that the performance differential is lowest for managed futures is consistent with the ease of running such strategies in multiple vehicles and the leverage available through the futures markets.

Conclusions

The initial appeal of the hedge fund model was that it enabled talented and motivated managers to pursue investment opportunities outside the constraints of registered investment products like mutual funds. Managers were relatively unfettered to pursue compelling investment opportunities as market conditions warranted. A talented merger arbitrage specialist in the late 1980s might have evolved into a distressed investor by 1990 and a buyer of nonperforming real estate portfolios within a few years thereafter.

The institutionalization of the business over the past decade has gradually introduced a series of new constraints into the investment model. Institutional investors are wary of style drift and value consistency in the investment process, sometimes even in the face of an inferior opportunity set. The concentration of capital among large firms post-crisis naturally has narrowed much of the investment universe to situations where managers can deploy hundreds of millions of dollars in a single position. Post-crisis aversion to gating/suspension risk has led to intense scrutiny of the liquidity of underlying portfolios.

A rational question for investors is whether the structural constraints of liquid vehicles cause the underlying managers to deviate from the core investment strategy to such a degree that it undermines the original investment thesis – that is, to invest in strategies with a higher expected risk adjusted return than, or low correlation to, traditional investments. Based on a cursory analysis, a recently launched mutual fund of managed accounts product appears to have underperformed the flagship hedge fund counterparts run by the same managers by 600 bps on a fee equivalent basis over just the first half of 2013. If anything, this suggests that investors will be sorely disappointed if they expect the mutual fund to approximate the performance of a portfolio of those hedge funds over time.

[1] The adverse selection issue was most acute with the HFRX Global Investable index versus either the HFRI Fund of Funds index or HFRI Fund Weighted index. Credit Suisse’s Blue Chip investable index did not suffer from nearly as much of a performance drag; however, this product was never designed to offer daily or weekly liquidity.

[2] The Dow Jones Credit Suisse Index, designed to track the universe of managed account and UCITS products, was launched in early 2011 but ceased reporting in May 2013. Consequently, comparative statistics are for the live period only.